2019 Third Quarter Review and Outlook

by | Oct 8, 2019 | Quarterly Reviews

The third quarter saw increased volatility with the bond market providing great returns then the stock market. For the first time since 2016, value stocks outperformed growth stocks. In the fourth quarter, we expect increased volatility as the market comes to the realization that the China trade issue is a long-term fight that won’t be easily solved. Going forward, we expect increased volatility in the stock market but we expect them to provide single digit returns and that will outperform the bond market.

The S&P 500 Index returned 1.70% for the third quarter. For the year, the S&P 500 Index returned 20.55%. Most equity asset classes showed small negative returns for the third quarter. The S&P Mid-Cap Index returned -.09% for the third quarter but has returned 17.87% for the year. The S&P Small Cap Index returned -.20% for the third quarter but has returned 13.46% for the year. We continue to recommend overweighting large cap stocks versus. mid and small cap stocks. The US Barclays Aggregate Bond Index returned 2.27% for the third quarter and has returned 8.52% for the year.


United States equities continued to outperform the rest of the world. International equities, as measured by the MSCI EAFE Index returned -1.12% for the third quarter and returned 12.80% for the year. Emerging markets, as measured by the MSCI Emerging Markets Index returned -4.43% for the third quarter and returned 5.36% for the first half of the year.

China, as measured by the MSCI China Index, returned -4.91% for the third quarter. At Virtue Asset Management, we believe that the trade dispute with China is only the beginning of a long-term fight. The goal of China 2025 is to transition the country up the manufacturing value chain and to focus on producing higher value products and services. Those higher value products and services are the industries that many U.S. companies successfully operate in. Critics of China complain that the model promotes unfair competition. It disadvantages U.S. companies by subsidizing Chinese companies and limiting access to China for U.S. Companies. Due to the competing goals of the United States and China, we don’t believe that any treaty could satisfy the current goals of both nations. We expect the tension to be an underlying trend over a long-time horizon. As a reminder, in the 80’s it took years for trade issues to be negotiated with Japan. Despite the tension with Japan, the 80’s were a very successful time period for U.S. equities. Hopefully, the market will come to this conclusion and stop overreacting over every piece of trade news – whether positive or negative.

In the third quarter, the Federal Reserve completed two .25% interest rate cuts. The current federal funds target rate is 1.75% to 2%. These cuts were made despite the second quarter real Gross Domestic Product (GDP) being up 2%. I recently heard Dallas Federal Reserve President Robert Kaplan saying that manufacturing data is a leading indicator for economic growth and that consumer numbers are typically a lagging indicator. He then commented that he has seen the trade uncertainty contributing to slower global growth and has already seen weakness in manufacturing. The manufacturing purchasing managers’ index (PMI) from the Institute for Supply Management came in at 47.8% in September, the lowest since 2009, marking the second consecutive month of contraction. Any figure below 50% signals a contraction. In addition, the new export orders index was only 41%, the lowest level since March 2009.

The market is now forecasting a 65% chance of a third .25% rate cut by year end. The market is also forecasting a 50% chance of two .25% rate cuts by the end of April 2020. The consequence of these cuts has been a large decrease in long term interest rates. At the beginning of the year the ten-year Treasury was yielding 2.66% and the thirty-year Treasury was yielding 2.97%. At the end of the third quarter the ten-year Treasury was yielding 1.68% and the thirty-year Treasury was yielding 2.12%. These rates compare to a 1.85% dividend for the S&P 500 Index. Investors need to compare the yield of the S&P 500 versus the dividend rates of government bonds. We believe that even if the S&P 500 provides lower than historic returns, most investors expect it to outperform the low yields of government bonds over the next ten and thirty years.

One of the fears of a low interest rate policy is that easy access to money creates a bubble in specific asset classes. As we mentioned in the first quarter, several high-profile companies went public this year. What made these companies unique is that despite extremely high valuations these companies had not posted any profits. The public market has recently shown less exuberance than the private equity markets for these high growth but negative profit companies. Lyft is down over 40% from their initial public price and Uber is down over 30% from their initial public price. The final sign of rationalization was forcing WeWork to pull their initial public offering because there was no demand at the price they were asking. The market’s reaction to these initial public offerings may be a sign of market sentiment moving from growth stocks to value stocks. In fact, in the third quarter the S&P 500 value Index returned 2.83% compared to the S&P 500 growth Index returning .72%.

Analyst earnings projections for 2019 have dropped from $155 from the end of the first quarter to $146 for a forward price to earnings ratio (P/E) ratio of 20.61. Over the last ten years the P/E ratio has averaged 19.76. Using the P/E of 19.76 multiplied by earnings of $146 for the S&P 500 provides a target of 2883. This is approximately 3% below the current level of the S&P 500. Analyst earnings projections for 2020 are at $166 a share for the S&P 500. We find these projections to be high, but it does show that analysts are not predicting a recession in 2020. Therefore, the risk to the downside is an adjustment to the P/E ratio. A small adjustment to the P/E ratio down to 17 times earnings would lower the Index to 2480 or approximately 17% lower than the current level. The last five years the P/E ratio has averaged 22.49. Using the P/E of 22.49 multiplied by earnings of $146 for the S&P 500 provides a target of 3281. This would be an increase of 10% from current level. Given the low interest rates we think it is more likely to see some P/E expansion from the current level. Given the current risk of a 3% drop compared to the reward of 10% we recommend that investors maintain their stock exposure at the neutral point of their target range with more exposure to value stocks.

Investing involves risk, including the possible loss of principal and fluctuation of value.  Past performance is no guarantee of future results.

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